The great stem cell dilemma

FORTUNE — Imagine yourself the proud but rueful owner of an ancient Jaguar. Every day you dread the uncertainty that comes with trying to get from here to there — there, more often than not, being the shop. No sooner does one ailment find repair than another appears. At best, it’s a slow, uncomfortable ride. Lonely too. There’s really no one around who fully understands your plight.

That is how Patricia Riley describes life in a 95-year-old body. Riley, who reached that milestone birthday last St. Patrick’s Day, lives alone in the same 1,100-square-foot house in Plainfield, Conn., that she’s called home for 64 years, having survived her husband (heart disease), a daughter (breast cancer), and every friend she ever had. “All the people I knew have all gone, Jeffrey,” she says in a quivering voice laced with melancholy. “They’ve all died. I go to church and I never see people my age.” Her remaining family includes two daughters, five grandchildren, and eight great-grandchildren, including my two young sons. In a nod to her French-Canadian heritage, we call her Méme.

Méme attributes her longevity to good genes, but she clearly owes a debt to modern medicine. Over the years she’s had a cholecystectomy, a hysterectomy, esophageal surgery, a stroke, and ulcerative colitis. Lately she relies on a cane and a walker, and her daily regimen includes pain pills for arthritis, two inhalers for asthma, high-blood-pressure meds, a statin, vitamins, digestion aids, and an anti-anxiety drug that she calls “my nerve pill.” Her vision also comes courtesy of medical science. Three years ago Méme was diagnosed with a form of age-related macular degeneration, or AMD, a disease of the back of the retina that is the leading cause of vision loss in the developed world. The ophthalmologist gave her a choice: a needle into her eyeballs every six weeks, or blindness. Méme opted for the injections and now receives shots of an off-label cancer drug called Avastin, which has demonstrated efficacy in halting the progress of her type of AMD. Holding the ailment at bay is all she can hope for. “I’ll have to go for as long as I live,” she says. “It’s just a treatment — it’s not a cure.”

Treatments, not cures. This, in a nutshell, is the MO of our health care system, and it’s precisely the reason that regenerative medicine — and stem cell therapy in particular — has been the subject of so much hope and hype over the past decade or so. Stem cell therapies promise to empower a body to fight ailments by enabling it to build new parts. Think about growing new neurons or heart tissue. Think about the difference between perpetually slathering that old Jag with Bondo and having it heal itself overnight in the garage.

While stem cells have ignited plenty of religious outrage and political grandstanding, behind the headlines the underlying science has been advancing the way science often does — by turns slowly and dramatically. To be clear, the earliest stem cell therapies are almost certainly years from distribution. But so much progress has been made at venerable research institutions that it now seems possible to honestly discuss the possibility of a new medical paradigm emerging within a generation. Working primarily with rodents in preclinical trials, MDs and Ph.D.s are making the paralyzed walk and the impotent virile. A stem cell therapy for two types of macular degeneration recently restored the vision of two women. Once they were blind. Now they see! Some experts assert that AMD could be eradicated within a decade. Other scientists are heralding a drug-free fix for HIV/AIDS. Various forms of cancer, Parkinson’s, diabetes, heart disease, stroke, and ALS have already been eradicated in mice. If such work translates to humans, it will represent the type of platform advancement that comes along in medicine only once in a lifetime or two. The effect on the economy would be substantial. Champions of stem cell research say it would be on the order of the Internet or even the transistor.

The obstacles along the road from lab rat to human patients are many, of course, but the biggest by far is money. With the dramatic events in the lab, you might think that a gold rush would be under way. That’s far from true. Long time horizons, regulatory hurdles, huge R&D costs, public sentiment, and political headwinds have all scared financiers. Wall Street isn’t interested in financing this particular dream. Most stem cell companies that have dared go public are trading down 90% or more from their IPOs. Sand Hill Road is AWOL. The National Venture Capital Association doesn’t even have a category to track stem cell investments.

Big Pharma would seem to be the most obvious benefactor. The drug companies understand the complexities (and billion-dollar outlays) involved in bringing therapies to market. A few drug companies have kicked the tires on stem cells over the years, but waiting for them to undo the current model is akin to banking on Big Oil to rethink energy. They may do it, but it’s unlikely to be by choice. Which leaves stem cell researchers begging for state and federal grants at a time scientific funding is under siege.

Insiders have a name for this moneyless purgatory between scientific prototype and market innovation. They call it the Valley of Death.

Robert Lanza is the chief scientist of Advanced Cell Technology (ACTC), a company whose scientific achievements are overshadowed only by its history of desperate business decisions. Sporting a few days of stubble and a salt-and-pepper crewcut, Lanza, 56, is sitting in his corner office at the modest headquarters in Marlborough, Mass. He speaks with an earnestness that belies a tough-guy Boston accent, his shirt open wide at the collar, baggy pants cinched tightly at the waist. It was Lanza who published a paper in The Lancet earlier this year detailing the results of early clinical trials involving the two women suffering from macular degeneration. A UCLA ophthalmologist injected each woman with 50,000 retinal cells derived from human embryonic stem cells, and according to the paper, both claim to have better vision as a result. They’re not 20/20. But after a single injection, one now walks the mall alone, uses her computer, and can pour a cup of coffee. The other sees colors and can read five letters on the eye chart.

If Lanza is remembered one day as the man who saved millions from blindness, his story will provide a ready-made biopic for Ben Affleck. Born in the hardscrabble town of Roxbury and raised by a professional gambler, he escaped the economic underclass through intelligence and imagination. At 13, he altered the DNA of a chicken to make it change color; the experiment was published in Nature. His sisters never graduated from high school. He received an MD from Penn and a Fulbright scholarship, and has collaborated with giants, including B.F. Skinner and Jonas Salk. He was the first ever to clone an endangered species, and now he’s the standard-bearer for stem cell research. Lanza experiments with several types of stem cells, but he feels human embryonic stem cells offer the most potential, at least in the short term.

Human embryonic stem cells are biological shape shifters. They uniquely possess the ability to become any other cell in the body, which makes them extraordinarily powerful and dangerous. When injected in an undifferentiated state or left unchecked in a petri dish, they form disgusting teratoma tumors consisting of many features — hair, skin, teeth, etc. But when properly directed to a desired outcome, they become healthy liver cells or heart muscle, wrinkle-free facial skin, or you name it. “The power of an embryonic stem cell is it’s the master cell,” says Lanza.

The controversy around these cells has to do with their origins. Scientists harvest them from an embryo that’s about four days old. Critics call this procedure akin to choosing the importance of one life (aging) over another (embryonic). It’s a powerful argument, ill-formed though it may be. Regardless of where one feels life begins, the embryos in question are donated byproducts of in vitro fertilization. What’s more, when treated properly, one set of donated cells will produce countless subsequent generations, so it’s not exactly a one-to-one tradeoff. Nevertheless, the religious and political right has decried the development of embryonic stem cell lines, and George W. Bush severed federal funding for their development. (The Obama administration restored it.) As Massachusetts governor, Mitt Romney once advocated for human embryonic stem cell research. Now he clearly does not. All of which makes investors, not to mention the researchers, extremely jittery.

Late last year the preeminent firm in the field, Silicon Valley’s Geron, abdicated its leadership position in the midst of the first-ever FDA-approved clinical trial for an embryonic-stem-cell therapy. Geron injected four spinal-cord patients with a treatment that had previously enabled paraplegic rats to walk, as a way to demonstrate safety in humans. By all accounts, the science appeared sound, and the injections were having no adverse effects. But Geron discontinued the program and exited the stem cell field, citing economic conditions and an uncertain path to market.

At that point, Lanza took the baton. And he’s naturally eager to differentiate himself from the fallen leader. During our meeting he’s in pitch mode, outlining the many ways that macular degeneration is different from spinal-cord injuries. Spinal-cord injuries represent a market of perhaps tens of thousands. Macular degeneration affects tens of millions. Repairing a spinal-cord injury requires making a long neurological connection to the brain. His AMD treatment works in a self-contained area on the back of the eyeball. “When we selected an application, we knew we needed a tiny number of cells and they just needed to do what they were doing in the petri dish,” Lanza says. What’s more, the macula doesn’t readily trigger the body’s immune system and is relatively easy to monitor for signs of efficacy and tumors. He even details how he’s routing around the controversy through science. He developed a way to harvest the embryonic stem cells without destroying the embryos.

Some scientists have criticized Lanza for rushing to publish results after injecting only two patients. Others are concerned about a placebo effect. Lanza addresses the skepticism in his paper. In person he waves it away. “You can’t fake seeing better,” he says. ACT has since initiated more trials involving dozens of AMD patients in Boston, Philadelphia, London, Los Angeles, and Miami — all at top-notch ophthalmology clinics. If those trials go as well as the first, Lanza will surely publish more papers and make the rounds on the talk show circuit. Assuming, that is, his company lasts that long.

It’s no sure thing. ACT has been scratching and clawing to survive for years. The company raised venture funding in the late ’90s and planned an IPO in the early 2000s, but then the biotech bubble broke and killed that dream. ACT became embroiled in a patent-infringement lawsuit that drained the coffers and forced the sale of key assets. “We were okay for a year or two, and then we ran out of that money,” Lanza recalls glumly. “We were living hand to mouth.” The phones were turned off; the water cooler and coffeemaker were hauled away. Meanwhile, a nearby stem cell company was targeted by a pipe bomb, putting the entire industry on edge. “I was always listening for noises,” he says. “There were busloads of picketers outside our office.”

In 2005, ACT completed a reverse merger with a public company and instigated a death-spiral financing strategy that massively diluted the stock. At the time, 22 million outstanding shares were selling for $7 each. Today, it’s 1.7 billion shares at 8¢. Having spent upwards of $100 million on research, the company received the okay from the FDA in late 2010 to commence the AMD clinical trials. A few days later the CEO died of a heart attack. Board member and hedge fund manager Gary Rabin took the CEO role and cleaned up the balance sheet, settling lawsuits and swearing off toxic debt. These days he says there’s money in the bank, and he’s hoping to do a reverse stock split with the aim of being listed on Nasdaq. Even then, success is hardly likely. Shares in almost any public stem cell company can be had for less than $1. One of the highest fliers, Stem Cells Inc. (STEM), reached $171 a share once upon a time. In mid-September it was trading at 95¢.

If the public markets don’t come around, Lanza and Rabin have a plan B. “We could choose to go down a path where we take cash from a potential partner,” Rabin says. “AMD’s toll on the health care system is extremely burdensome because of the aging of the population. So this is one of the great opportunities for large-cap pharma to pursue.”

It has been a common refrain for desperate stem cell companies — at some point Big Pharma will come around. There are, finally, signs that the drug companies are becoming interested. In 2009, Novartis (NVS) stepped up research programs focusing on regenerative medicine. The company is focusing on stem cells both as therapies and as tools for drug discovery. The same holds true at GlaxoSmithKline (GSK), which has a $25 million, five-year partnership with the Harvard Stem Cell Institute. “It’s been a renaissance for stem cell science in the last two to three years,” says Jason Gardner, head of R&D for GSK’s regenerative medicine unit. “Of course lots of the science is risky and early. So we are very interested in risk-sharing partnerships that also share in the upside.”

In what would surely be music to Lanza’s ears, Gardner considers the clinical data on the AMD trial to be encouraging. “It’ll be interesting to see over the next five years whether diseases in the back of the eye could be treated in the same way we do the front of the eye,” he says. “Cornea transplants are done every day.”

The biggest patrons by far of stem cell research are the citizens of California — who have, over the years, led the country on health care issues from pollution standards to anti-tobacco legislation to bicycle helmets. Eight years ago voters passed Proposition 71, allocating $3 billion to establish the California Institute for Regenerative Medicine and create a nexus for biotech research that would be analogous to Silicon Valley.

CIRM’s first chairman, Bob Klein, who runs an investment-banking consultancy in Palo Alto, was a key figure in drafting the measure. It was Klein who pushed the idea of bypassing the legislature and appealing directly to the people. “In the 20th century we used bonds to finance harbors and bridges and roads,” he says. “Research is the infrastructure of the 21st century, and bonds can be used just as they were historically, with the same benefits for the economy as well as society.”

The $1.7 billion awarded so far has made one obvious mark on the state: a dozen gleaming research institutions. CIRM has proved adept at getting billionaires to donate funds to the cause. Insurance magnate turned philanthropist Eli Broad and his wife, Edythe, donated $75 million to research centers at the University of Southern California, UCLA, and the University of California at San Francisco — the last a striking post-modern series of aluminum-wrapped trailers perched along a bedrock hill on exposed steel trusses. Business Wire founder Lorry I. Lokey contributed $75 million to a sparkling facility at Stanford University. Pimco founder Bill Gross and his wife gave $10 million to the University of California at Irvine’s stem cell labs. In all, CIRM awarded almost $271 million in building grants and attracted more than $560 million from donors to build 823,000 square feet of research space. CIRM contends that those infrastructure investments have lured more than 100 world-class researchers, a crucial first step in creating a locus of research and industry.

With half of the $3 billion allocated, it’s not too early to ask whether the agency has made any progress in bridging the Valley of Death. Agency officials are quick to point out that 561 research grants have led to more than 1,200 peer-reviewed papers addressing 38 incurable diseases. But CIRM’s only link to a clinical trial so far has been with Geron, which received a $25 million loan. “I want to make it very clear that we got all our money back, plus interest,” says CIRM’s current chairman, Jonathan Thomas.

Now that the infrastructure is in place, CIRM is making a beeline for the clinic with $437 million in grants aimed at bringing therapies to trial within five years. The targeted diseases are a murderers’ row, including Type 1 diabetes, heart failure, leukemia, and stroke. One recent grant recipient is expected to begin a clinical trial in post-heart-attack patients within months.

A handful of companies, including ACT, have either relocated or expanded their California operations in hopes of attracting the same type of money that CIRM recently doled out to Stem Cells Inc. — $40 million for work on cervical spinal-cord injury and Alzheimer’s disease. “Companies will assume the mantle of taking products to market,” says Thomas. “We’re looking to have them involved more and earlier in the process.”

The agency also plans to fund research on more so-called orphan diseases, like ALS, which cause great suffering and have no alternative means of treatment. The FDA tends to fast-track therapies for such conditions, which could help smooth the path for subsequent therapies. “We’re revisiting our strategic plan to get some work into the clinic and solidly established. We need to demonstrate that cell therapies will work. There is an urgency to do that now,” says CIRM president Alan Trounson.

Trounson has high-profile targets in mind as well. “The science stands up that we can cure HIV. My feeling is, let’s get that done,” he says. “Let’s make it a vaccination strategy and eradicate the damn thing. That’s a shot on goal, and I think we’ll take it.”

There’s a pattern to how scientists describe the potential impact of stem cells on the economy and society at large. Think about the Interstate Highway System or the Internet. They weren’t built overnight, but once they got rolling, they manifested themselves in ways no one dared imagine. And increasingly, despite the economic hardship, prominent scientists suggest we have arrived at an inflection point. “The potential to make advances in this field has never been better. In part that’s because of the wonderful tools at our disposal — genetic sequencing, imaging techniques, cell sorting. We can do things in a day that used to take half a year. And the cost is going down,” says Arnold Kriegstein, director of the UCSF center. “The last 10 years have been turbulent times, almost like the Wild West, but the landscape is now better defined. The field is stabilizing. It’s maturing. I’d be surprised in 10 to 15 years if there aren’t some cell-based therapies that work.”

In search of a business mind similarly hopeful about the prospects of a legitimate industry emerging, I call bond genius and UC Irvine donor Bill Gross. “Goodness, you’re talking to the wrong guy,” he says. “Our donation had nothing to do with business. It wasn’t even really an investment. We have a 23-year-old son who was one of the first test-tube babies in Orange County. That’s not about stem cells, but it is high-tech science. This was about a partnership with the state and a partnership with humanity, I guess.”

Touching, but not what I was hoping for. I try Eli Broad, whose foundation has given generously to many causes, including the arts, education reform, and genomics research. “The greatest promise of improving the human condition is in stem cell research and genomics,” says Broad. “I cannot predict all the economic benefits any more than I could have predicted the economic benefits of NASA. I cannot predict how it goes from here to bedside, but it’s going to happen.” Spoken like a billionaire who can afford not to worry about a return on investment.

Finally, I visit someone who’s even more familiar with how game-changing industries are born: Andy Grove, one of the godfathers of the semiconductor industry. He has invested in four biotech funds, is involved in a clinical trial of a drug for Parkinson’s disease, has pledged as much as $40 million to the Michael J. Fox Foundation, and has been thinking a lot about the promise of stem cells lately. And yet, at his own foundation’s office in Los Altos, I find him to be surprisingly full of doom and gloom. He rejects any comparison of stem cells to transistors. “The sun shone on that industry. The government had a stake, the consumer had a stake, and the telecommunications industry had a stake,” he says. “This industry is just as important, but after that the similarities are gone.”

For close to two hours, Grove argues passionately about how the FDA is enabling predatory offshore industries by impeding progress and the many reasons financiers want no part of stem cells. “VCs aren’t interested because it’s a shitty business,” he says. Big Pharma? Forget it. CIRM? “There are gleaming fucking buildings everywhere. That wasn’t necessary.” When I press him to be constructive, he wearily offers one possible solution. Rather than courting billionaires to put their names on buildings, we need a system of targeted philanthropy in which the 99% can sponsor the individual stem cell lines that matter to them.

Even suffering from Parkinson’s at 76 years old, Grove has plenty of fire in him. On this issue he seems particularly zealous, and clearly frustrated. He argues until he’s exhausted, and politely asks if we may conclude. On parting, he looks me in the eye, shakes my hand, and offers one final thought. “What you’re trying to do is extremely difficult, but also extremely worthy,” he says. “I don’t envy you. But you’ll be a better man for it when it’s done.”

It was clear during our talk that Grove wants an economic model for stem cell research and development to emerge, even if he’s not willing to bet money on its happening. And that puts him in good company. According to a recent Gallup poll, 62% of Americans now consider embryonic stem cell research to be morally acceptable, and that attitude is pretty consistent across all age groups. It’s a healthy sign that public sentiment is strengthening in the way it often does with scientific breakthroughs. First we fear the different or unknown. Then we realize how much it may help us or the ones we love. It’s hard to imagine that there was once moral outrage over in vitro fertilization now that it’s become fodder for reality television.

There are some signs that financiers and the government may be starting to come around as well. Ten years ago the National Institutes of Health allocated $181 million to human-stem-cell research. Last year the amount was more than $500 million. “There has been growing enthusiasm in the biomedical community and at the NIH about the promise of stem cells,” says James Anderson, director of planning and strategic initiatives. The agency established the NIH Center for Regenerative Medicine in 2010 and is collaborating with the Defense Advanced Research Projects Agency and the FDA to develop a “clinical trial on a chip” to speed the path from laboratory to market. Anderson considers it an important development that “should vastly reduce risk while increasing the total number of new therapies that can be tested and reducing overall costs.”

Maybe the most hopeful sign of all is a shift in the way the scientists are thinking about their work. The stem cell industry may not have yet found its own Gordon Moore or Andy Grove, but the academics are beginning to think like entrepreneurs. Hans Keirstead is a good example. He’s the founder of UC Irvine’s stem cell research program and chairman of the scientific advisory board for California Stem Cell. Keirstead is far from the typical wonky professor. He plays guitar, wears a thumb ring, drives a Porsche 911, and flies a helicopter. He’s also the scientist who developed the stem cell therapy that enabled crippled rats to walk. CSC is funded by angels and furnished with a pool table, a gas fireplace, a chef’s kitchen, and photos of Keirstead with Keanu Reeves, Ed Bradley, Warren Buffett, and Bill Gates. None of that is reason to believe he has a sustainable business on his hands. But he does have an interesting revenue model. CSC sells high-purity cell platforms to Big Pharma for high-throughput drug screening. The income partially finances the development of stem cell therapies for cancer, spinal muscular atrophy, and ALS. “We’ve positioned ourselves to take advantage of the blue sky of therapeutics,” he says, “while the widgets cover our burn rate.”

Keirstead also has progressive ideas about how to lower development costs. He wants to offshore clinical trials in the same way corporate America has outsourced business processes. Many stem cell scientists worry about the U.S. losing a stem cell arms race to China. But Keirstead wants to drag the industry there on his terms. He recently founded China Stem Cell in Shanghai, and expects to start conducting trials there before long. “If you look at the old companies, with all their ups and downs and tiring out investors, they just have so much internal baggage,” he says. “Running trials in China would be cheaper. I’m not advocating that people skirt FDA quality. Take the standards with you. You can do 100 or 1,000 patients there and be 20% of the cost of an American trial.”

There’s a theory in evolutionary biology called punctuated equilibrium. It proposes that things don’t happen gradually. We go through vast periods of stasis in which the status quo rules, and then, once in a great while, profound disruption occurs. The theory also seems to apply to social progress. It often happens via revolutions. Forget the highways, the transistor, and the Internet. We needn’t look back a decade to see how a strategic investment can yield enormous returns. By one estimate, the federal government’s $3.8 billion investment into the Human Genome Project has netted $796 billion in economic benefits, including 310,000 jobs and $244 billion in personal income. Those numbers are growing every day.

It’s easy to imagine the benefits of stem cell therapies reaching even further. Scientists are doing their part, and there are signs that the government and the citizenry are increasingly excited. Will the money follow? The citizens of California have spoken. If my grandmother and I had the power to get the rest of the country to follow, we would.

In my final reporting trip, I make a cross-country trek to take Méme to the doctor to witness what I imagine will be the horror of her eyeball injections. For our 20-mile drive to New England Retina Associates, I rent a Nissan Quest. “It’s like a Cadillac!” she beams as I help her into the passenger seat.

At the clinic, I follow her from room to room for a few hours, observing quietly while she undergoes retinal imaging and testing, and then brace myself for the needle as though it were going into my own eye. The doctor treats as many as 15 patients a day, and when it’s Méme’s turn, the moment comes and goes in a flash. It leaves her visibly shaken, and it’s certainly not a cure, but at least she knows she’s good for another six weeks.

We move slowly back to the van, and I do my best to provide a comfortable ride. Heated seats. Cruise control. We enter the passing lane, grab hands, and hold on for the drive back to where so many of my childhood memories were formed. Her eyes are closed, resting. The road passes smoothly beneath our wheels.